Tag: Payment System

Moneyness: Let’s stop regulating crypto exchanges like Western Union

J.P. Koning offers an interesting contribution to the crypto regulation debate focussing on the problem with using money transmitter licences to manage businesses which are very different to the ones the framework was designed for …

The collapse of cryptocurrency exchange FTX has been gut-wrenching for its customers, not only those who used its flagship offshore exchange in the Bahamas but also U.S. customers of Chicago-based FTX US.

But there is a silver lining to the FTX debacle. It may put an end to the way that cryptocurrency exchanges are regulated – or, more accurately, misregulated – in the U.S.

U.S.-based cryptocurrency exchanges including Coinbase, FTX US, and Bianca.US are overseen on a state-by-state basis as money transmitters.

— Read on jpkoning.blogspot.com/2022/11/lets-stop-regulating-crypto-exchanges.html

Tony – From the Outside

The empire strikes back?

There is a lot written about how bad the US payment system is and why crypto solutions are the future. Against that background, Tom Noyes recently published an interesting post setting out his thoughts on a project JPM Chase is running to reengineer their payment system. Tom’s posts are normally restricted to subscribers but he has unlocked the first in a 5 part series exploring what JPM Chase is doing.

His post is definitely worth reading if you are interested in the future of banking. The short version is that the traditional banking system is not sitting still while crypto and fintech attempt to eat its lunch.

Tony – From the Outside

Those ACH payments

One of the mysteries of finance is why the USA seems to be so slow in adopting the fast payment systems that are increasingly common in other financial systems. Antiquated payment systems in TradFi is a frequent theme in DeFi or stablecoin pitches which argue that they offer a way to avoid the claws of the expensive, slow and backward looking traditional banks.

Every time I read these arguments in favour of DeFi and/or stablecoins, I wonder why can’t the USA just adopt the proven innovations widely employed in other countries. I had thought that this was a problem with big banks (the traditional nemesis of the DeFi movement) having no incentive to innovate but I came across this post by Patrick McKenzie that suggests that the delay in roll out of fast payment systems may in fact lie with the community banks.

The entire post is worth reading but I have appended a short extract below that captures Patrick’s argument on why community banks have delayed the roll out of improved payment systems in the USA

Many technologists ask why ACH payments were so slow for so long, and come to the conclusion that banks are technically incompetent. Close but no cigar. The large money center banks which have buildings upon buildings of programmers shaving microseconds off their trade execution times are not that intimidated by running batch processes twice a day. They could even negotiate bilateral real-time APIs to do so, among the fraternity of banks that have programmers on staff, and indeed in some cases they have.

Community banks mostly don’t have programmers on staff, and are reliant on the so-called “core processors” like Fiserv, Jack Henry & Associates and Fidelity National Information Services. These companies specialize in extremely expensive SaaS that their customers literally can’t operate without. They are responsible for thousands of customers using related but heavily customized systems. Those customers often operate with minimal technical sophistication, no margin for error, disconcertingly few testing environments, and several dozen separate, toothy, mutually incompatible regulatory regimes they’re responsible to.

This is the largest reason why in-place upgrades to the U.S. financial system are slow. Coordinating the Faster ACH rollout took years, and the community bank lobby was loudly in favor of delaying it, to avoid disadvantaging themselves competitively versus banks with more capability to write software (and otherwise adapt operationally to the challenges same-day ACH posed).

“Community banking and Fintech”, Patrick McKenzie 22 October 2021

Tony – From the Outside

Matt Levine on stablecoins

Quite a lot has been written about the backing of stablecoins but Matt Levine uses the Tether use case to pose the question how much it matters for the kinds of activities that Tether is used for …

The point of a stablecoin is not mainly to be a secure claim on $1 of assets in a bank account. The point of a stablecoin is mainly “to grease the rails of the roughly $1 trillion cryptocurrency market,” by being the on-blockchain form of a dollar. We talk somewhat frequently about stablecoins that are openly backed by nothing but overcomplicated confidence in their own value; to be fair, we mostly talk about them when they are crashing to zero, but still. The thing that makes a stablecoin worth a dollar is primarily that big crypto investors treat it as being worth a dollar, that they use it as a medium of exchange and a form of collateral and value it at $1 for those uses. Being backed by $1.003 of dollar-denominated safe assets helps with that, but being backed by $0.98 of dollar-denominated assets might be good enough?

Matt draws no distinctions above but I don’t I think his argument is intended to apply to stablecoins that aim to challenge the traditional payment service providers (“payment stablecoins”) operating in the broader financial system. It does however pose an interesting question about how much stability crypto traders really require.

Tony – From the Outside

Fed Finalizes Master Account Guidelines

The weekly BPI Insights roundup has a useful summary of what is happening with respect to opening up access to Fed “master accounts”. This is a pretty technical area of banking but has been getting broader attention in recent years due to some crypto entities arguing that they are being unfairly denied access to this privileged place in the financial system. BPI cites the example of Wyoming crypto bank Custodia, formerly known as Avanti, which sued the Kansas City Fed and the Board of Governors over delays in adjudicating its master account application.

The Kansas Fed is litigating the claim but the Federal Reserve has now released its final guidelines for master account access.

The BPI perspective on why it matters:

Over the past two years, a number of “novel charters” – entities without deposit insurance or a federal supervisor – have sought Fed master accounts. A Fed master account would give these entities – which include fintechs and crypto banks — access to the central bank’s payment system, enabling them to send and receive money cheaply and seamlessly. BPI opposes granting master account access to firms without consolidated federal supervision and in its comment letter urged the Fed to clarify which institutions are eligible for master accounts.

The BPI highlights two main takeaways from the final guidelines:

The Fed does not define what institutions are eligible to seek accounts and declined to exclude all novel charter from access to accounts and services.

The guidelines maintain a tiered review framework that was proposed in an earlier version, sorting financial firms that apply for master accounts into three buckets for review. Firms without deposit insurance that are not subject to federal prudential supervision would receive the highest level of scrutiny. The tiers are designed to provide transparency into the expected review process, the Fed said in the guidelines — although the final guidelines clarify that even within tiers, reviews will be done on a “case-by-case, risk-focused basis.”

The key issue here, as I understand it, is whether the crypto firms are really being discriminated against (I.e has the Fed been captured by the banks it regulates and supervises) or whether Crypto “banks” are seeking the privilege of master account access without all the costs and obligations that regulated banks face.

Let me know what I am missing

Tony – From the Outside

History of the Fed

I love a good podcast recommendation. In that spirit I attached a link to an interview with Lev Menand on the Hidden Forces podcast. The broader focus of the interview is the rise of shadow banking and the risks of a financial crisis but there is a section (starting around 21:20 minute mark) where Lev and Demetri discuss the origin of central banking and the development of the Fed in the context of the overall development of the US banking system.

The discussion ranges over

  • The creation of the Bank of England (23:20)
  • The point at which central banks transitioned from being simple payment banks to credit creation (24:10) institutions with monetary policy responsibilities
  • The problems the US founders faced creating a nation state without its own money (25:30)
  • Outsourcing money creation in the US to private banks via public/private partnership model (26:50)
  • The problems of a fragmented national market for money with high transmission costs (27:40)
  • The origin of the Federal Reserve in 1913 (31.50) and the evolution of banking in the US that preceded its creation which helps explain the organisational form it took

… and a lot more including a discussion of the rise of shadow banking in the Euromarket.

The topic is irredeemingly nerdy I know and it will not tell you much new if you are already engaged with the history of banking but it does offer a pretty good overview if you are interested but not up for reading multiple books.

Tony – From the Outside

Stablecoin business models – I need a dollar

There has been a lot written on stablecoins in the wake of Terra’s crash. Matt Levine has been a reliable source of insight (definitely worth subscribing to his “Money Stuff” newsletter) but I am also following Izabella Kaminska via her new venture (The Blind Spot).

Maybe I am just inexplicably drawn to anything that seeks to explain crypto in Tradfi terms but I think this joint post by Izabella and Frances Coppola poses the right question by exploring the extent to which stablecoin issuers will always struggle to reconcile the safety of their peg promise to the token holders with the need to make a return. The full post is behind a paywall but this link takes you to a short extract that Izabella has made more broadly available.

Their key point is that financial security is costly so your business model needs an angle to make a return … to date the angles (or financial innovations) are mostly stuff that Tradfi has already explored. There is no free lunch.

If it’s financially secure, it’s usually not profitable

So, what was the impetus for issuers like Kwon to focus on these innovations? For the most part, it was probably the realisation that conventional stablecoins – due to their similarities with narrow banks – are exceedingly low-margin businesses. In a lot of cases, they may even be unprofitable.

This is because managing other people’s money prudently and in a way that always protects capital is actually really hard. Even if those assets are fully reserved, some sort of outperformance has to be generated to cover the administration costs. The safest way to do that is to charge fees, but this hinders competitiveness in the market since it generates a de facto negative interest rate. Another option is cross-selling some other service to the captured user base, like loan products. But this gets into bank-like activity.

The bigger temptation, therefore, at least in the first instance, is to invest the funds in your care into far riskier assets (with far greater potential upside) than those you are openly tracking.

But history shows that full-reserve or “narrow” banks eventually become fractional-reserve banks or disappear.

“Putting the Terra stablecoins debacle into Tradfi context”, Frances Coppola and Izabella Kaminska, The Blind Spot

Tony – From the Outside

The E-Cash alternative

CBDCs and stablecoins have been getting most of the attention lately. In contrast the release in late March 2022 of a draft bill titled the ECASH Act seems to have flown under the radar. The bill as I understand it is only a proposal at this stage and not something actively in the process of becoming law. It is however worth noting for a couple of reasons

  • Is is a useful reminder that an account based CBDC is not the only form of government issued digital money that might be pursued (though the account based model does seem to be the model preferred by the BIS mostly due to concerns about illegal use of anonymous forms of money)
  • Primary responsibility for E-Cash is assigned to the US Treasury, not the Central Bank (so technically it is not a CBDC per se)
  • Although I personally am not overly concerned by the current state of Know Your Customer and related anti money laundering, anti terrorist financing requirements applied to bank accounts, I respect the views of those for whom privacy is a priority or don’t have the benefit of living in the kind of economy/society that allows me to be relaxed about these questions
  • So long as the digital form of cash is subject to an equivalent set of controls on illicit activity as is applied to physical cash, then I can’t see why the digital option should be prohibited
  • Adding a digital money option that is capable of operating in an off-line environment also looks to me like a useful (albeit limited) level of redundancy and resilience in a world that increasingly relies on a 24/7 supply of power and internet connectivity for money to function
Who needs e-cash?

You can find more detail about the proposal here but for those short of time the argument put up by the Act’s proponents for why someone might want to use E-Cash is summarised as those who:

1. Lack access to traditional banking/payments services;

2. Value privacy and wish to avoid surveillance and/or data-mining;

3. Are concerned about third-party censorship and/or discrimination;

3. Lack reliable internet or digital network connectivity; and

5. Are low-income and/or cannot afford high transaction, withdrawal, and exchange fees.

www://https.ecashact.us/#whyuse

The Act’s proponents emphasise however that “… E-Cash, like physical cash, does not pay interest, and offers less third-party protections than traditional bank accounts or payments app (chargebacks, loss and fraud-prevention, etc).” The basic idea is that this is a complement to the existing forms of money (physical and digital) and it is not envisaged that most people will seek to hold large amounts in the form of E-Cash.

What exactly does the ECASH Act proposes?

1. Directs the Secretary of the Treasury to develop and introduce a form of retail digital dollar called “e-cash,” which replicates the offline-capable, peer-to-peer, privacy-respecting, zero transaction-fee, and payable-to-bearer features of physical cash, and to coordinate their efforts with other agencies, including the Federal Reserve through an intergovernmental Digital Dollar Council led by the Treasury Secretary;

2. Establishes an Electronic Currency Innovation Program within the U.S. Treasury to test and evaluate different forms of secure hardware-based e-cash devices that do not require internet access, third-party validation, or settlement on or via a common ledger, with a focus on widely available, interoperable architectures such as stored-value cards and cell phones;

3. Establishes an independent Monetary Privacy Board to oversee and monitor the federal government’s efforts to preserve monetary privacy and protect civil liberties in the development of digital dollar technologies and services, and directs the Treasury Secretary to, wherever possible, promote and prioritise open-source licensed software and hardware, and to make all technical information available for public review and comment; and

4. Establishes a special-purpose, ring-fenced Treasury overdraft account at the Federal Reserve Bank of New York to cover any and all government expenses related to the development and piloting of E-Cash, and directs the Board of Governors of the Federal Reserve System to take appropriate liquidity-support measures to ensure that the introduction of e-cash does not reduce the ability of banks, credit unions, or community development financial institutions to extend credit and other financial services to underserved populations, as prescribed under the Community Reinvestment Act of 1977 and related laws.

www:https://ecashact.us/#ecashact

Summing up

I have been a professed sceptic on the need for a retail CBDC in advanced economies with well functioning fast payment systems (see here and here) but this proposal is intriguing and one that I will watch with interest.

Tony – From the Outside

Central bank digital currencies: a new tool in the financial inclusion toolkit?

The BIS recently published a paper summarising what had been learned from a series of interviews with nine central banks exploring how these institutions were thinking about the potential of a CBDC to support the pursuit of “financial inclusion” objectives explicit or implicit in their mandates.

A lot of what the paper documents and discusses will be pretty familiar to anyone who has been following the BIS and individual central banks on this topic but I think the following observations offered by the paper about the best way to pursue financial inclusion is worth noting

It needs to be noted that many of these features [i.e. the benefits of a CBDC] can, in isolation, be offered by other payment innovations, and many gaps could be addressed through regulation and sound oversight arrangements. Combining different payment innovations – such as open application programming interfaces (APIs), fast payment services, contactless chips and QR codes – could achieve many of the same goals. This is particularly true when accompanied by robust regulatory and oversight arrangements that public authorities can use to catalyse private sector players, enforce sound governance arrangements and foster required coordination and collaboration. Adoption of relevant technologies for supervisory and regulatory compliance could also improve the efficiency and effectiveness of regulators and supervisors. What is truly different about CBDC is that it is a direct claim on the central bank. It is an open question for central banks whether CBDCs or other policy interventions are the best fit for their jurisdiction. Yet if a CBDC is to be issued (for financial inclusion or other motives), interviews with central banks clearly point to the importance of inclusive design elements to successfully promote inclusive outcomes. We discuss these elements in the next subsection.

Page 13, paragraph 16

There is a narrative that sees CBDC adoption as inevitable based in part on the fact that so many central banks are looking at the question. In contrast, the BIS paper clearly states that a CBDC is not a “panacea” and that many of the outcomes a CBDC might deliver could equally be delivered by other payment innovations such as “open application programming interfaces (APIs) , fast payment services, contactless chips and QR codes”

It is also worth noting that, of the nine central banks interviewed, eight were emerging market and developing economies and only one (Bank of Canada) an advanced economy. The results should therefore be interpreted with that bias in mind.

Summing up, my take is that

  • the business case for a retail CBDC seems to have the most weight in the emerging market and developing economies with relatively poorly developed financial infrastructure
  • the business case for a retail CBDC in an advanced economy is less obvious
  • other initiatives such as central bank sponsorship of fast payment systems might be a better use of central bank resources
  • not explicitly referenced in the paper, but the recent experience with the roll out of fast payment systems in Brazil and India offer interesting case studies
  • the central bank focus on CBDCs seems to continue to be heavily weighted toward account based systems
  • token based CBDCs are mentioned in passing but do not seem to be high on the list of priorities

Let me know what I am missing

Tony – From the Outside

SWIFT …

… has been in the news lately.

This link takes you to a blog I follow written by Patrick McKenzie that offers a payment expert’s perspective on what SWIFT is, together with Patrick’s personal view on what the sanctions are intended to achieve.

This short extract covers Patrick’s assessment of the objective of the sanctions

The intent of this policy has been described variously in various places. In my personal opinion, I think the best articulation of the strategy is “We are attempting to convey enormous displeasure while sanctioning some banks which are believed to be close to politically exposed Russians, while not making it impossible for Russian firms generally to transact internationally nor sparking a humanitarian crisis either inside or outside of Russia.”

One of the key insights is that SWIFT manages the messaging that accompanies international payments and facilities their processing, not the transfers of money per se. The sanctions do not make it impossible to transact with Russia, they mostly make it operationally very difficult and not really worth the effort, especially at scale. Especially if you are a regulated bank who cares about your long term relationship with your regulator.

Another nuance that does not always come through in the newspaper reporting of the sanctions is the extent to which the compliance functions in banks are under pressure to interpret and anticipate the intent of the regulatory sanctions

Many commentators confuse the actual effects of severing particular banks from SWIFT with what they perceive as the policy goal motivating it. More important than either is, in my opinion, what it communicates about commander’s intent to the policy arms who are responsible for enforcing it.

Specifically, it communicates that Something Has Changed and that Russian institutional money, specifically “oligarch” money, is now tainted, and not in the benignly ignored fashion it has been for most of the last few decades.

Where there is some doubt or ambiguity, banks are likely to err on the side of caution.

Patrick’s post is worth reading if you are interested in this particular aspect of SWIFT and his blog worth following if you are interested in payments more generally.

Tony – From the Outside